Yes, Closed-End Fund Yields Are High, but There’s a Catch

"Not all yields are created equal," warns S&P Capital IQs Alec Young.

By Joyce Hanson|August 22, 2012 at 11:30 AM

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Closed end funds have created excitement this year among the yield-hungry—with yields in the range of 6%, 7% and even 8%—but before investors in search of income-oriented closed-end funds get too enthusiastic, they should check out whether the fund they’re interested in uses leverage.

Leverage, says Alec Young, a global equity strategist with S&P Capital IQ, is often used to increase income in the closed-end fund world, especially in a yield-starved environment such as the one we’re in right now. And while leverage isn’t necessarily a bad thing, it does introduce a higher element of risk along with those high yields, which is why investors need to know what they’re getting into.

“It’s a very underappreciated concept,” Young said in a recent interview. “Investors need to find out whether the fund managers will be using leverage. It doesn’t mean if they are that it isn’t a suitable investment, but it’s something that you have to do due diligence around, because it does raise the risk profile of the fund. Leverage can magnify your upside, in that you’ll get a bigger yield, but not all yields are created equal. Using leverage, you can get a 6%, 7% or 8% type of yield, but you have to understand that the price of these funds is more volatile, because when prices go down, they’re more exposed.”

For example, Young said, a closed-end fund might have $100 million in assets, and the manager will leverage that base and buy a total of $150 million worth of income-producing assets, such as stocks or bonds. The fund will earn yield on the larger amount that includes borrowed money, but the yield only applies to the fund’s base amount.

The Upside and the Downside of Leverage

That’s the upside. The downside, Young added, is if the assets decline in value.

“You can lose money at a faster rate,” he said. “So if you have a $100 million fund and you’re using leverage to buy $150 million in assets, it’s important that the assets be stable to rising in value. Or, if they’re falling, that the income they produce offsets what the capital loss is. The problem is, if you have $150 million in assets and you own that with leverage, and the assets start to decline, it magnifies the losses on your $100 million.”

Conservative investors in the closed-end space would want a fund that has no leverage and would take a much lower yield, while a leveraged fund would be more appropriate for a more aggressive, income-oriented investor, Young concluded.

But Alan Goodson, product head for Aberdeen Asset Management, which specializes in international, Asia-Pacific and emerging-markets closed-end funds, asserts that a closed-end fund’s ability to use leverage sets it apart from the pack.

“An advantage of a closed end fund compared with a mutual fund or exchange-traded fund (ETF) is its ability to use leverage,” Goodson said in a recent interview. “From an investment management perspective, you have a fixed pool of capital, unlike an open-end fund, where shareholders obtain their liquidity from the fund itself, and the fund is continually growing or shrinking in size.”

While acknowledging that leverage has both benefits and drawbacks, Goodson said the key benefit for income-producing funds that use leverage is their ability to borrow money on a short-term basis.

“The leverage is used to provide a supplement to the income-producing objective of the fund,” Goodson said. “If you can borrow using short-term rates and invest effectively on long-term rates, then you can use that carry to boost the level of income that you can deliver to your shareholders. The downside to using leverage is naturally what comes with that: greater volatility of the net asset value (NAV) and therefore, indirectly, the share price of the fund.”

RiverNorth/Manning & Napier’s Proprietary Twist

S&P Capital IQ’s Young said that because income-generating products have become such a “crowded theme,” any new fund out there, closed-end or not, must garner investor assets by relying on a truly special proprietary twist.

For RiverNorth Capital Management and Manning & Napier Advisors, the proprietary twist in their new Dividend Income Fund (RNMNX) involves an open end fund that invests opportunistically in closed-end funds.

Launched on Aug. 7, RNMNX proposes to capitalize on the inefficiencies within the closed-end fund market and combine that with stock picking focused on publicly traded companies’ free cash flow yield. The tactical closed-end fund equity strategy invests in equity closed-end funds while the dividend-focus strategy invests in dividend-paying common stocks of mid- to large-cap companies.

RiverNorth Chief Investment Officer Patrick Galley noted that about 70% of closed-end funds implement leverage, and this is why they have become known as yield securities. This creates RNMNX’s opportunity, Galley said in a recent interview.

“A lot of that yield comes from leverage,” Galley said. “That’s the double-edged sword: risk. When times are bad, closed-end fund losses can be exacerbated. That’s something we can take advantage of. We are a contrarian. When markets are doing well, that’s an opportunity for us to sell into that positive sentiment.”

‘Leverage Can Help a Fund’

Unlike an open-end mutual fund or ETF, closed-end funds go through an initial public offering process where a fixed number of shares are issued, he explained. For people who bought the IPO, the only way to sell is to find a willing and able buyer. Therefore, the market price deviates from the NAV, meaning the liquidation value of the underlying assets.

“That’s the opportunity that we’re taking advantage of,” Galley said. “When the closed-end funds start trading in the secondary market, inevitably that market price deviates from the NAV. Most of the time, they start to trade at a discount to the NAV, but sometimes they do trade at a premium.”

Given that there are 630 closed-end funds—fixed income, equity-based and tax-free muni bond closed-end funds—“you can really get any type of asset class exposure you can think of with a closed-end fund,” Galley said. “And a lot of times that discount or premium is dictated by sentiment because most closed-end funds are owned by retail investors.”

So why should a retail investor (or an advisor, for that matter) invest in a closed-end fund?

“If you’re investing for the long term and your true objective is just income, leverage can be beneficial,” Goodson said. “Leverage can help a fund, but it can deliver greater volatility of the share price. It’s important for shareholders to understand that.”

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